The more central bankers explain themselves, the more confused the markets get

“Forward guidance” the old-fashioned way.
“Forward guidance” the old-fashioned way.
Image: Reuters/Ralph Orlowski
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Ben Bernanke is doing it. Mario Draghi and Mark Carney are doing it, too—as are most of the world’s most powerful central bankers.

Forward guidance“ is de rigueur in central banking circles. The thinking goes like this: By signaling their future interest rate-setting intentions, the transparency and predictability of central banks’ interest rate decisions is improved, the theory goes. By laying out clear rules for when they will hike or cut rates, or committing to a certain policy stance for a set period of time, central bankers give the markets more clarity and certainty about the future path of interest rates. The markets hate uncertainty, we are always told, so the introduction of forward guidance by the US Federal Reserve, European Central Bank and Bank of England over the past year should usher in a new era of stability and predictability in financial markets.

Why, then, have we seen two rather spectacular surprises in monetary policy decisions over the past two months? In September, the Fed caught the markets off guard when it decided not to taper its purchases of US treasury bonds. Today the ECB wrong-footed investors by cutting its main benchmark interest rate when most analysts expected it to stay put. In both cases, bond and currency markets reacted violently to the announcements, suggesting that portfolios were not well positioned for what Fed chair Bernanke and ECB head Draghi eventually said.

Clear as mud

So, have economists lost their powers of prediction? Monetary policy is a blunt instrument at the best of times, and don’t forget that economics is a fuzzy kind of science—witness how two economists with diametrically opposed views both won Nobel Prizes this year. Beyond that, it’s possible that the veneer of predictability offered by forward guidance gives market watchers a false sense of security in their convictions about the future. When Bernanke makes suggestive comments about slowing bond purchases “later this year,” economists may fixate on this specific nugget and overlook all of the vague caveats and hedges around it. Since Carney introduced forward guidance at the Bank of England in August, he has fought perceptions that the bank’s economic outlook is too pessimistic, and thus its triggers for rate hikes will be tripped sooner than the bank is letting on.

When the ECB introduced guidance in July—pledging to keep interest rates “at present or lower levels for an extended period of time”—more analysts were convinced that rates would remain on hold through 2014 than before the new policy language was introduced. Disregard the euro zone’s recent flirtation with deflation—this is the central bank that raised interest rates twice in 2011 and is based in Germany, where the fear of inflation outranks unemployment, cancer, terrorism and much else besides.

Few investors yearn for the days when central banks simply sprang rate changes on the markets without explanation, much less press conferences. Still, when it comes to explaining themselves, lately central bankers have been no more successful in signaling their intentions to the markets than when the famously inscrutable Alan Greenspan ran the Fed. As he once said, “If I turn out to be particularly clear, you’ve probably misunderstood what I’ve said.”